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September 20, 2012

The QE3 Tightrope: Relief at the End, Inflation Danger Below

Success would mean a better economy just one year from now, AEI economist says—but what if the plan fails?

Walking a tightrope over Niagara Falls is how American Enterprise Institute scholar John Makin explains the Fed’s bold new approach to monetary stimulus:

“Success will be exhilarating, but failure will be ugly,” he says.

In an economic outlook paper released Thursday, Makin dissects a policy whose abstruseness might easily obscure the true risks and rewards at the heart of a Fed policy the AEI scholar terms not QE3 but rather QE3+. What is new and particularly bold about this new iteration of monetary easing is the open-ended nature of the Fed’s commitment. As the key line in last Thursday’s Fed announcement put it:

“If the outlook for the labor market does not improve substantially, the committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

Makin calls the unconditional nature of these continued asset purchases “extraordinary” for three reasons. First, they are to continue indefinitely until the labor market improves; second, no allowance is made for the possibility of failure, despite the fact that asset purchases to date have not given labor markets the boost policymakers have sought; third, the statement is ambiguous about what the Fed's policy response to inflation might be.

Moreover, in assuring markets that its accommodative stance will endure through at least through mid-2015, the Fed is signaling a willingness to tolerate rising inflation.

Says Makin: “We are looking at a ‘whatever it takes’ monetary policy that may result in a much weaker dollar and higher gold and stock prices as the United States exports deflation (stronger foreign currencies) into a world of weak demand growth.”

The AEI scholar is not wholly critical of QE3+. He says the approach derives from scholarly work by Fed Chairman Ben Bernanke (left) and others who have studied Japan’s failure to avert the sluggishness that characterized its lost decade of the 1990s. Bernanke and other scholars of monetary policy believe Japan’s key mistake was losing the courage to maintain its initial quantitative easing over fears of igniting inflation.

With QE3+, Makin hopefully states that “if the Fed can raise wealth-enhancing asset purchases and hiring by displaying a willingness to risk higher inflation but not permanently boosting inflation expectations, the economy will be better off a year from now than it is today.”

But the policy requires the Fed to be “somewhat irresponsible by promising to tolerate the threat of higher inflation for a longer period than previously thought prudent,” and it has to deliver on its promise of bringing about jobs and economic growth.

But, Makin warns, “if inflation continues to rise while labor market conditions do not improve, eventually the Fed will need to withdraw extra stimulus or risk further bouts of still-higher inflation.”

Already, QE3+ has increased inflation expectations, as implied by a 30-basis-point rise in longer-term U.S. bond interest rates in the days following last week’s Fed announcement. Continued inflation worries as QE3+ continues could eventually adversely affect bond and stock prices, the dollar and the cost of servicing the government’s debt.

Though “the chances of success with QE3+ are not zero,” Makin warns that the result of policymakers losing their grip on the easy-money approach could be an “eventual period of rapidly rising inflation and interest rates like what characterized the late 1970s and early 1980s.”

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